Marie Fitzpatrick, Senior Director, shares her views on the challenges asset managers would face with regulation increases and the risks of implementing liquidity limits.
Marie was recently quoted in Ignites Europe, a Financial Times service which covers the asset management industry in Europe. You can read the article here.
Is regulation necessary and what could more regulation mean for asset managers?
Regulation is necessary and should provide a clear framework for asset managers and suitable protection for investors. As always, it’s a case of balancing the benefits that a given regulatory measure might bring against the ‘cost’ of that measure in terms of the efficient function of markets. Clearly when an exceptional event, such as the Coronavirus pandemic, occurs there will be greater attention on the role and scope of regulation and the key is to look for genuine improvements while at the same time not overreacting for the long-term or introducing knee-jerk responses.
The asset management industry is already relatively heavily regulated, so more regulation will tend to increase complexity and cost. This not only has an impact on the profitability of asset managers, but can manifest as additional costs for investors and in some instances could have unintended consequences that actually end up limiting or delaying the ability of markets and economies to recover from such crises as capital is further restricted for deployment.
Looking at liquidity specifically, this was already a focus for regulators before the Coronavirus pandemic due to some well-publicised issues with funds that held less liquid assets. The common themes of new or proposed regulation in this area have been:
- Better identification and categorisation of funds that invest in illiquid assets, such as the FCA’s new rules on ‘funds investing in inherently illiquid assets’ (FIIA)
- Pragmatic measures to better match the possible levels of redemption demand with the time that managers of illiquid assets need to trade the underlying assets to free up cash, such as the FCA consultation CP20/15 on liquidity mismatch in authorised open-ended property funds
- Regular stress testing by asset managers that help better align the liquidity risk management practices of individual managers with appropriate guidelines, such as the ESMA guidelines on liquidity stress testing in UCITS and AIF’s, which actually have 16 separate sets of guidelines to avoid falling foul of the inflexibility of a ‘one size fits all’ approach
- Better reporting and notification of liquidity events, such as the new IFM notification requirements announced by the CSSF in May, which looks at pragmatic ‘triggers’ such as daily net redemptions exceeding 5% of NAV or net redemptions over a calendar week exceeding 15% of NAV
What’s worth remembering is that if an asset manager has set up a closed-ended structure, their investor base is committing that capital for the life of the fund, so the investor knows from the start that there is no liquidity available to them unless they look to a secondary buyer who may not offer them market value. Open-ended and listed investment funds or trusts have more liquidity options built in, such as daily, monthly, quarterly or annual redemption options. However in times of crisis some managers will freeze their funds to protect their wider investor base and avoid a fire sale of underlying assets that would not be in the best interests of either the fund or the majority of investors. The key is to ensure that such terms are made clear to investors as part of the sign up process.
What are the risks of implementing liquidity limits?
The risk of regulation that imposes liquidity limits could be to inadvertently ‘paralyse’ certain markets in a way that prevents divestments or acquisitions simply because capital is not available. Different asset classes behave in different ways during turbulent times and it would not make sense to impose liquidity restrictions in a blanket manner. Asset managers need to be able to set their own agendas and limits around liquidity and then communicate those very clearly to investors as part of their offering.
At the asset level, implementing liquidity limits doesn’t really make sense as it could take away a manager’s ability to react swiftly to changes in the market, which in turn would be detrimental to the fund’s performance and therefore not be in the best interests of the investor base. Ensuring an asset manager acts within the boundaries it has set for its investment activity and communicates clearly to its entire investment base is regulated and captured under the Alternative Investment Fund Managers Directive (AIFMD) where an AIFMD Depositary’s duties include oversight of the fund manager.
Do you think liquidity factors will become more of a factor for investors when choosing funds in future? If so, which types of funds in particular?
From what we have seen in the market, a good proportion of investors seem to have remembered lessons from the financial crisis of 2008/2009 and are applying them in response to the pandemic. Many have continued to allocate capital to a wide range of funds, including those investing in illiquid assets, based on the belief that the aftermath of the pandemic will bring about plenty of investment opportunities and possibly lead to strong vintages in the years that follow.
Should asset managers be more explicit about liquidity limits?
Asset managers are explicit about their liquidity risk management practices and limits and these usually form part of the private placement memorandum (PPM) or limited partnership agreement (LPA). If the aim is to make these more prominent, there are communications methods that asset managers can use to achieve that goal and it may well be that many do so proactively as a way of differentiating themselves post crisis.
Ultimately it is up to investors to conduct thorough due diligence prior to making an investment and there will always be a balance between potential gains, appetite for risk and ‘worst case scenario’ contingencies. Investors commit their capital based on investment terms and parameters set-out in the legal agreements and, as long as managers operate within those and communicate their actions in a clear and timely manner, it is questionable what benefit further disclosures might bring.
Or do investors just have to accept in times of market disruption, there is less/no liquidity?
To a degree, yes. The pandemic is a classic ‘unforeseen event’ and it is difficult to regulate for an unexpected crisis that has such far-reaching impact. Investors, especially those choosing to invest in more illiquid assets, need to think about and accept downside risk. They have a choice around whether to sign up to closed-ended, open-ended or listed investments and the latter two inherently offer more liquidity options. Equally, in times of severe market disruption, it is not unreasonable to allow asset managers mechanisms to protect the best interests of the majority of investors and prevent the forced sale of assets below market valuation.
If you have any questions in relation to this article please contact Marie directly.